Chap003 PDF

Managerial Economics &
Business Strategy
Chapter 3
Quantitative Demand Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. The McGraw-Hill Companies, Inc., 2006
Overview
I. The Elasticity Concept
Q
Q
Q
Q
Own Price Elasticity

Elasticity and Total Revenue
Cross-Price Elasticity
Income Elasticity
II. Demand Functions

Q
Q
Linear
Log-Linear
III. Regression Analysis

The Elasticity Concept

How responsive is variable G to a change
in variable S
EG , S
% G
=
% S
If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
The Elasticity Concept Using

Calculus
An alternative way to measure the elasticity
of a function G = f(S) is
EG , S
dG S
=
dS G
If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
Own Price Elasticity of

Demand
EQX , PX
%QX
=
%PX
Negative according to the law of demand.

Elastic:
EQX , PX > 1
Inelastic: EQX , PX < 1

Unitary:
EQX , PX = 1
Perfectly Elastic &

Inelastic Demand
Price
Price
D
D
Quantity
Perfectly Elastic ( EQ X ,PX = )
Quantity
Perfectly Inelastic ( EQX , PX = 0)
Ujian - Dijelaskan hubungan-hubungannya
Own-Price Elasticity
and Total Revenue
Elastic
Q
Increase (a decrease) in price leads to a decrease (an

increase) in total revenue.
Inelastic
Q
Increase (a decrease) in price leads to an increase (a

decrease) in total revenue.
Unitary
Q
Total revenue is maximized at the point where demand

is unitary elastic.
Elasticity, Total Revenue and Linear

Demand
P
100
TR
10
20
30
40
50

Demand
P
100
TR
80
800
10
20
30
40
50
10
20
30
40
50

Demand
P
100
TR
80
1200
60
800
10
20
30
40
50
10
20
30
40
50 Q

Demand
P
100
TR
80
1200
60
40
800
10
20
30
40
50
10
20
30
40
50

Demand
P
100
TR
80
1200
60
40
800
20
10
20
30
40
50
10
20
30
40
50

Demand
P
100
TR
Elastic
80
1200
60
40
800
20
10
20
30
40
50
10
20
30
Elastic
40
50

Demand
P
100
TR
Elastic
80
1200
60
Inelastic
40
800
20
10
20
30
40
50
10
Elastic
20
30
40
Inelastic
50

Demand
P
100
TR
Elastic
80
Unit elastic
Unit elastic
1200
60
Inelastic
40
800
20
10
20
30
40
50
10
Elastic
20
30
40
Inelastic
50
Factors Affecting
Own Price Elasticity
Q
Available Substitutes
The more substitutes available for the good, the more elastic
the demand.
Time
Demand tends to be more inelastic in the short term than in
the long term.
Time allows consumers to seek out available substitutes.
Expenditure Share
Goods that comprise a small share of consumers budgets
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.
Cross Price Elasticity of

Demand
EQX , PY
%QX
=
%PY
If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.
Predicting Revenue Changes

from Two Products
Suppose that a firm sells to related goods. If the price of
X changes, then total revenue will change by:
( (
R = R X 1 + E Q X , PX + RY E QY , PX % PX
Income Elasticity
EQX , M
%QX
=
%M
If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.
Uses of Elasticities
Pricing.
Managing cash flows.
Impact of changes in competitors prices.
Impact of economic booms and recessions.
Impact of advertising campaigns.
And lots more!
Example 1: Pricing and Cash

Flows
According to an FTC Report by Michael
Ward, AT&Ts own price elasticity of
demand for long distance services is -8.64.
AT&T needs to boost revenues in order to
meet its marketing goals.
To accomplish this goal, should AT&T
raise or lower its price?
Answer: Lower price!

Since demand is elastic, a reduction in price
will increase quantity demanded by a
greater percentage than the price decline,
resulting in more revenues for AT&T.
Example 2: Quantifying the

Change
If AT&T lowered price by 3 percent, what
would happen to the volume of long
distance telephone calls routed through
AT&T?
Answer
Calls would increase by 25.92 percent!
EQX , PX
%QX
= 8.64 =
%PX
%QX
8.64 =
3%
d
3% ( 8.64 ) = %QX
d
%QX = 25.92%
Example 3: Impact of a change

in a competitors price
According to an FTC Report by Michael
Ward, AT&Ts cross price elasticity of
demand for long distance services is 9.06.
If competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?
Answer
AT&Ts demand would fall by 36.24 percent!
EQX , PY
%QX
= 9.06 =
%PY
%QX
9.06 =
4%
d
4% 9.06 = %QX
d
%QX = 36.24%
Interpreting Demand Functions

Mathematical representations of demand curves.
Example:
d
QX = 10 2 PX + 3PY 2 M
X and Y are substitutes (coefficient of PY is
positive).
X is an inferior good (coefficient of M is
negative).
Linear Demand Functions

General Linear Demand Function:
QX = 0 + X PX + Y PY + M M + H H
d
P
EQX , PX = X X
QX
Own Price
Elasticity
EQX , PY
PY
= Y
QX
Cross Price
Elasticity
M
EQX , M = M
QX
Income
Elasticity
Example of Linear Demand
Qd = 10 - 2P.
Own-Price Elasticity: (-2)P/Q.
If P=1, Q=8 (since 10 - 2 = 8).
Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
Log-Linear Demand
General Log-Linear Demand Function:
ln Q X d = 0 + X ln PX + Y ln PY + M ln M + H ln H
X
Cross Price Elasticity : Y
Income Elasticity :
M
Own Price Elasticity :
Example of Log-Linear
Demand
ln(Qd) = 10 - 2 ln(P).
Own Price Elasticity: -2.
Graphical Representation of
Linear and Log-Linear Demand
P
D
Linear
D
Q
Log Linear
Regression Analysis
One use is for estimating demand functions.
Important terminology and concepts:
Q
Q
Q
Q
Q
Least Squares Regression: Y = a + bX + e.

Confidence Intervals.
t-statistic.
R-square or Coefficient of Determination.
F-statistic.
An Example
Use a spreadsheet to estimate the following
log-linear demand function.
ln Qx = 0 + x ln Px + e
Summary Output
Regression Statistics
Multiple R
0.41
R Square
0.17
Adjusted R Square
0.15
Standard Error
0.68
Observations
41.00
ANOVA
df
Regression
Residual
Total
Intercept
ln(P)
SS
1.00
39.00
40.00
MS
3.65
18.13
21.78
Coefficients Standard Error

7.58
1.43
-0.84
0.30
3.65
0.46
t Stat
5.29
-2.80
Significance F
7.85
0.01
P-value
0.000005
0.007868
Lower 95%
4.68
-1.44
Upper 95%
10.48
-0.23
Interpreting the Regression

Output
The estimated log-linear demand function is:
Q
Q
ln(Qx) = 7.58 - 0.84 ln(Px).

Own price elasticity: -0.84 (inelastic).
How good is our estimate?

Q
t-statistics of 5.29 and -2.80 indicate that the estimated coefficients

are statistically different from zero.
R-square of .17 indicates we explained only 17 percent of the
variation in ln(Qx).
F-statistic significant at the 1 percent level.
Conclusion
Elasticities are tools you can use to quantify
the impact of changes in prices, income, and
advertising on sales and revenues.
Given market or survey data, regression
analysis can be used to estimate:
Q
Q
Q
Demand functions.
Elasticities.
A host of other things, including cost functions.
Managers can quantify the impact of

changes in prices, income, advertising, etc.

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Managerial Economics &

Own Price Elasticity

II. Demand Functions

III. Regression Analysis

The Elasticity Concept

If EG,S > 0, then S and G are directly related.

The Elasticity Concept Using

If EG,S > 0, then S and G are directly related.

Own Price Elasticity of

Negative according to the law of demand.

Inelastic: EQX , PX < 1

Perfectly Elastic &

Ujian - Dijelaskan hubungan-hubungannya

Increase (a decrease) in price leads to a decrease (an

Increase (a decrease) in price leads to an increase (a

Total revenue is maximized at the point where demand

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Elasticity, Total Revenue and Linear

Cross Price Elasticity of

If EQX,PY > 0, then X and Y are substitutes.

Predicting Revenue Changes

If EQX,M > 0, then X is a normal good.

Example 1: Pricing and Cash

Answer: Lower price!

Example 2: Quantifying the

Example 3: Impact of a change

Interpreting Demand Functions

Linear Demand Functions

Example of Linear Demand

Own Price Elasticity :

Least Squares Regression: Y = a + bX + e.

Coefficients Standard Error

Interpreting the Regression

ln(Qx) = 7.58 - 0.84 ln(Px).

How good is our estimate?

t-statistics of 5.29 and -2.80 indicate that the estimated coefficients

Managers can quantify the impact of

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